Preparing for fundraising: investor due diligence, red flags, and error correction

Investors are aware of numerous cases in which founders make unfortunate mistakes and, therefore, do not receive the money they want. 

AIN talked to professional investors and asked them to tell us how to check startups before investing, what can signal the failure of a future deal, and how founders should prepare for fundraising. 

We spoke with Andrii Brodetskyi, investment analyst at Horizon Capital; Andrew Zinchuk, co-founder of ZAS Ventures; Evelina Holovanova, USF coordinator; Bohdan Svyrydov, investment director at Horizon Capital and u.ventures, and Daria Yaniieva, investment director at Sigma Software Labs.

Due diligence: How investors evaluate startups before making deals

Company valuation is both an art and a science, says Horizon Capital investment analyst Andrii Brodetskyi. And from the early to the later stages of a company’s development, it becomes less and less like an art and more like a science. 

From the investor’s point of view, the company’s valuation depends on the fundraising stage, Brodetskyi says. When a company does not yet have revenue or even a working product, the key things an investor evaluates is the team: what people are working on the startup, their track record, and what they have built before. 

Daria Yaniieva, investment director at Sigma Software Labs, says the team must deeply understand the problem and be willing to devote their lives to the work. In this case, investors will be able to get results faster. “An idea alone, without a team, is worthless,” she says.

Yaniieva says soft skills are equally important in the early stages of raising investment, as they characterize founders as people, not professionals.

For example, a startup founder’s sporting achievements show they can achieve their goals. Conquered mountain peaks, running marathons, and so on point to the same. These accomplishments make up the founder’s background; although these are unmeasurable indicators, investors also pay attention to them. 

At the same time, Andrew Zinchu, co-founder of venture capital firm ZAS Ventures, adds that it’s worth analyzing the entire team, even those who are involved in the project in part-time positions.

According to Brodetskyi, the team should generally include people with complementary competencies: hackers, responsible for the technical part, and hustlers, accountable for the business component. 

“If you have two or three hackers together, it’s a perfect team combination, but they must find at least one hustler. And vice versa — if people without a technical co-founder want to build something technically complex, it’s unlikely to work.” 

Among the factors that investors pay attention to, Zinchuk highlights Founder-Investor Fit. You can check it with the “airplane test.” Ask yourself: Would you like to spend 7-12 hours on an airplane with your partner in the next seat?” Moreover, not only the investor but also the founder should feel comfortable communicating. Our speaker compares the process of investing to marriage to understand better why it is crucial for partners to find a common language. 

Work experience in a well-known company is the next point that investors pay attention to, says Brodetskyi. It is pretty indicative if the founder has worked for a long time in companies like Google or Microsoft and held senior positions. 

A founder’s education can also be a positive signal to investors. According to investment analysts, sometimes, a young person does not have the opportunity to develop an appropriate track record in a startup. Instead, if they graduated from a prestigious university, this may indicate a strong basis in technical and economic knowledge. 

The ability to test hypotheses is one of the factors that the ZAS Ventures team considers before investing, says Andriy Zinchuk. He evaluates how well a startup team has tested its hypotheses on real users by conducting CustDev beforehand.

Working in a growing market allows companies to grow with it, which is another indicator that investors pay attention to. According to Horizon Capital’s investment analyst, even the strongest people cannot build a successful business in a small market that is growing too slowly or losing its relevance. By the way, the combination of the market and its players generates another important indicator for investors.

Founder-Market Fit is the matching of the founder’s skills to the market where they are building a startup. Brodetskyi explains that if people have a strong background in DeepTech or Hardware domains and set out to create a complex FinTech, “the puzzle may not fit together.” Therefore, the founder must have industry expertise.

Product-Market Fit: Investors care about how well a company knows its customers. According to Zinchuk, a startup at an early stage of raising funding is still far from Product-Market Fit, and we can discuss it closer to Series A. Then, the company will know exactly how much investment is needed to scale and capture the market. However, it is important to understand your audience at the beginning of a startup’s development.

The market potential of a product determines the assessment of competition. Daria Yaniieva from Sigma Software Labs says that startup competitors do not always have similar products on the market. 

The product’s market potential is an indicator that determines the competition assessment. Daria Yanieva says that a startup’s competitors do not always have similar products.

“There is an example I often give in my lectures: Speaking about kids’ toys, the true competitors are not always toys. It can be YouTube, which keeps your child busy. That is, something that already fills the need you are trying to solve, but in a different way.”

The scale of the issue the startup proposes to solve and its relevance. Both the founder and the investor must determine how relevant the problem is to the product’s users and whether it is repeatable. These indicators affect a startup’s valuation and profitability. 

USF coordinator Evelina Holovanova cites an analogy popular among venture capitalists: Is the problem a startup solves a “vitamin” or a “painkiller?” By “vitamin,” she means reasonable solutions but not life-saving. “Painkillers,” in this case, are solutions that make life difficult to imagine without.

“At one time, Airbnb and Revolut were such solutions, which completely changed our lifestyle and habits,” Holovanova cites an example. 

Velocity, or the speed at which a startup develops compared to similar startups on the market. The co-founder of ZAS Ventures says that a company can grow steadily by 10% every month. Or it can have an acceleration, i.e., first by 10%, the next month by 15%, and then by 20%. Such tracking shows the company’s progress over time.

A 12-month business plan and its metrics. The business plan should provide the founder with enough resources to release the product, while the founder should have money left over for growth. “If you have 30% or more monthly growth, absolutely all investors will be interested in you. It will be easy for you to raise a round,” Zinchuk says. However, he adds that the metrics, in this case, should correspond not to the pre-seed but to the seed round when the investor starts looking not at the team and vision but at the company’s specific business performance.

Daria Yaniieva singles out the technical co-founder as a CTO on the team as an indicator that investors also consider. This is important when it comes to technological products.

Budgeting is a factor that investors evaluate at the pre-seed stage. It concerns how founders structure the budget, even if it is a one- or two-year forecast. 

Legal compliance. This is a matter of jurisdiction, i.e., whether licenses and other permits are required where the startup is registered and plans to enter the market. For example, if a MedTech startup is seeking to enter the US market, does it need the FDA [Food and Drug Administration] permission? According to Andrew Zinchuk, compliance with legal regulations is very important for the overall understanding of the startup’s potential and the cost of its realization: “If you need a permit from the FDA, and you need to do some research for that, it can take four to five years. First, it all costs money. Secondly, it is also costly to maintain such a startup.”  

Investment conditions. The co-founder of ZAS Ventures says that a startup can meet all an investor’s expectations but have a high valuation. That’s why the investor won’t be able to finance the company. Zinchuk gives an example from his own experience. He was once approached by a founder who lived in the UK. He had a pre-seed round, an existing MVP, and the founder valued the startup at 10 million pounds. “I told them: “Guys, I like everything, but this is a huge valuation for me. We focus on Ukrainian founders in Ukraine because there is no capital here. You are great, but there are many foundations in the UK that will give you money at this valuation. I can’t invest in your company.”

A pilot project or MVP is an indicator for later rounds, such as seed ones, says Andrii Brodetskyi. Then, an investor has the opportunity to get feedback on the product from users, not from the founder. The investment analyst points out that the company founder himself highlights mainly the positive aspects of their project.

When analyzing a startup, an investor needs to assess the company’s potential and the conditional probability of achieving it. Bohdan Svyrydov, investment director at Horizon Capital and u.ventures, names the following criteria that should be considered:

• The extent to which the target customers have a significant need for the company’s solution or product.

• The size and prospects of the market.

• The quality of the team, including its market and operational expertise, and whether this team is among the best in the world to seize the market opportunity and build a successful company despite current and future competition.

• How well the product aligns with the needs of the target customers.

• The level of competition and the company’s competitive advantages.

• The quality of the startup’s financial and operational performance relative to its stage of development and industry.

• The team’s short- and medium-term plans, as well as the company’s long-term vision for growth.

Summarizing, his colleague Andrii Brodetskyi notes that new evidence-based metrics become available with each new funding round, helping investors evaluate a startup and determine whether it is moving in the right direction. In the early stages, the emphasis is primarily on the team, but later on, there’s no need to focus on the individual’s profile, as the founder will already be able to demonstrate growth in product usage, revenue, and other key metrics.

Daria Yaniieva does not deny the importance of the team factor but adds that it will no longer be the main factor in the later stages of funding. “Numbers will come into play. They are a clear plan of how the business develops, grows, and its exit strategy. That is, the factors will be different at different stages of financing,” Yaniieva says.

Illustrative image. Source: engin akyurt via Unsplash

Founders’ red flags — a signal of a failed deal for an investor at the analysis stage

🚩 Unbalanced distribution of startup shares between founders and investors. If the founders’ share remains small in two or three investment rounds, they will lose motivation. On the other hand, by giving investors a small share of the startup to keep a larger one, founders run the risk of not attracting good investors. 

🚩 Incorrect IP registration. According to a representative of Sigma Software Labs, correct IP registration is one of the most essential points for investors because it regulates what exactly the company you are investing in owns. 

🚩 Unbalanced team. For example, one that does not have a technical co-founder or a person who would take responsibility for business issues. 

🚩 Lack of market potential. If a product works in one or two markets, and its development is not further promoted, or founders do not see the need for it, this is a business with limited potential. The venture capital model is different because a startup has to make a profit for investors and scale up. “You invest in many companies and realize that only a few will make it. So you look at each story as something that can bring 100 times more profit than now. But if you don’t see this in a startup, it’s a problem,” Yaniieva says.

🚩 Unprofessional communication. Andrii Zinchuk calls the founder's lies a bright red flag for an investor, which can ruin his reputation once and for all. And he adds: "The investment community is small, and angels and venture funds communicate among themselves. Information about fraud by the founder of a particular startup becomes known to all members of the community as soon as it surfaces.

🚩 Incorrectly analyzed market. Sometimes, investors encounter incorrectly defined TAM (Total Addressable Market), SAM (Serviceable Available Market), and SOM (Serviceable Obtainable Market) in startup pitch decks. Based on these metrics, they may conclude that the founder does not understand the market and how to achieve the desired results, says Andrew Zinchuk, co-founder of ZAS Ventures. He advises startups to consider several key aspects in advance:

• What market they are entering

• What kind of customers they will attract

• What tools they will use and how much it will cost

• What is the competition in the market

• How many resources are needed

• What kind of team should be formed, etc.

🚩 Mismatch between a startup’s valuation and its traction. If a company has good traction in the Ukrainian market, it does not mean that it can get the same valuation as a startup developing in the US market.  

Zinchuk explains, “Once a founder came to me and said: ‘We have impressive traction — 50-60 thousand dollars MRR. We saw that you invested in such a startup with such a valuation, even though it has its traction in the American market and, accordingly, an American valuation. We want the same valuation.’ I said, ‘That’s great, but you have traction in Ukraine, you haven’t sold a single dollar in the US, and you don’t know any clients there. The chances that you will succeed are low.’ They came back to me four or five months later, and it turned out that they actually didn’t succeed in the US because everything was different there. I can’t predict the future. But there are certain things that you understand based on experience.”

🚩 Unrealistic timeline. These are situations when a company sets very ambitious goals that cannot be achieved for a short period — AIN’s interlocutors call this a signal that the founders are either trying to sell the startup to the investor in any way or have no business expertise.

🚩 Slow growth. Investment analyst Andrii Brodetskyi says that gradual, small growth is expected for some domains, such as DeepTech, BioTech, or Life Science because developing and certifying technology takes a lot of time.

When it comes to more understandable fields, such as e-commerce, B2B, and SaaS, investors have certain expectations from founders regarding the growth schedule, which is measured in terms of money or product users. But if years go by and the founders raise a round of funding but still fail to build anything, then obviously, something is going wrong. 

“If we plot the years of a startup’s life and its cash flow, we see a positive graph at the beginning of the startup’s development because investors have given money. Then the company loses and loses, and then loses less and less. Eventually, it passes this break-even point and continues to earn more every year.” 

According to Bohdan Svyrydov, low growth rates indicate a low-growth market, lack of sufficient demand for the product/solution, poor customer engagement, non-compliance of the product/solution with market requirements, loss to competitors, or inability to stand out among them. Horizon Capital’s investment director notes that one or more factors could play a role. 

🚩 Assessment of the company’s debt. Evelina Holovanov notes that startups with a large amount of debt and insufficient cash flow to service it can be a risky investment. 

🚩 Low retention rates — customer and revenue retention relative to benchmarks in the relevant industry (Enterprise SaaS, SMB SaaS, consumer apps, e-commerce, etc.). Bohdan Svyrydov believes that this indicator reflects a product or solution’s low value or quality.

“From a financial point of view, low retention is a hole from which the company’s revenue flows out and because of which the company must constantly attract a large number of new customers to at least maintain its revenue at the same level,” says Bohdan Svyrydov. 

🚩 Poor unit economics. This occurs when a startup earns less from its customers than it spends on acquiring them or doesn’t earn enough to cover all expenses and reach profitability, remaining reliant on venture capital funding. This red flag can indicate weak demand for a product or solution, a market with strong competitors, a fragmented market with a large number of competitors offering similar products or solutions with a similar level of value to the customer, as well as weak customer engagement, explains Bohdan Svyrydov. 

How founders can prepare for a funding round

Timely fundraising. It can take about six months, so you shouldn’t wait until you run out of money. Andrii Brodetskyi talks about the negative consequences of late fundraising: in order not to close the company due to lack of money, founders start firing good specialists, which harms the startup. He recommends looking for investment all the time: once you’ve closed one round, you begin forming a vision and contacts for the next.

Andrew Zinchuk advises coming to ZAS Ventures six months before fundraising so that investors have time to analyze the company and observe its development, and founders have time to get acquainted with the foundation. 

Develop a fundraising strategy. According to Daria Yaniieva, fundraising in the Ukrainian industry has no beginning and no end, because the industry is quite closed and everyone knows each other. That’s why reputation is important, and you need to constantly improve the product, maintain communication with investors, and process feedback. 

Create a list of investors. Before reaching out to potential investors, Andrew Zinchuk advises checking what stage of startups the investor typically invests in, the size of their typical investments, and what they have already invested in (to avoid internal competition with other portfolio companies).

“We often see startups at a pre-seed stage writing to VCs that invest in companies at series A or B. Firstly, it takes away the investor’s time. Second, this is not your target audience,” says Daria Yaniieva. 

Andrii Brodetskyi also believes that having a list of potential investors is essential to avoid approaching those who do not invest in the industry or the geographic regions where the startup is operating. Instead, Brodetskyi thinks the pool of potential investors should still be large.

“To get results, you need to have a lot of contact with investors, but you shouldn’t add extra investors because it’s a waste of time, especially yours,” the investment analyst says. He recommends establishing warm contacts with investors, which results in a much higher conversion rate. Also, having your mutual acquaintances recommend the startup to the investor will send a positive signal to the investor. 

Prepare your pitch deck and data room — a startup presentation and all the necessary documents for the investor to check your company. 

In a data room, it makes sense to collect all the company’s financial indicators, documents on legal entities, SAFE, Convertible Loan Agreements, etc. It’s better to prepare in advance so that you don’t have to delay the process of sending documents during the round. 

Speaking about the design of the pitch deck and data room, Andrii Brodetskyi advises not to reinvent the wheel but to leverage existing open data, as leading foundations and accelerators like Y Combinator and Sequoia do.

“Best practices are based on the experiences of hundreds and thousands of companies, so it’s better not to overthink it but simply follow the recommendations of professionals,” the expert says. 

Create a narrative. According to Andrii Brodetskyi, investors like to invest in a story. If your startup is at a very early stage of development, the story can be your strong team, track record, or the market you plan to enter. An investment analyst says that a compelling story should have two factors: why you can build it and how it will turn into a scalable business. 

Keep in touch with your investor. Brodetskyi advises sending updates on the startup once a quarter or a month — not only to existing but also to potential investors. This way, investors will know the dynamics of the startup’s development.